Fund Accounting: A Must for Nonprofits

If you’re still unsure what fund accounting is, we’ve provided you with the basics you need for your nonprofit organization.

Updated May 26, 2020

Fund accounting is an accounting method used to determine accountability rather than the profitability of an organization. Fund accounting helps organizations properly recognize revenue and expenses for each individual program.

What is fund accounting?

Fund accounting or nonprofit accounting emphasizes accountability. It’s used by nonprofits, service organizations, and government entities to properly account for funds received from various sources.

Because funding for nonprofit organizations and government entities comes from taxpayers, foundations, or the public, a greater emphasis is placed on properly accounting for those funds, which is where fund accounting comes in.

For example, when a nonprofit runs a campaign for earthquake relief, the funds raised must go towards earthquake relief, unless the donor states otherwise.

If the nonprofit later holds a hunger relief campaign, the funds raised from that campaign must be held and accounted for separately from the funds raised from the earthquake relief campaign.

This same principle applies to government fund accounting. If you look at your property tax bill, you’ll see that your tax is applied to various government programs. All of those programs must be accounted for separately to ensure that your tax dollars are used properly.

Nonprofits are also tasked with properly managing grant funds, particularly since nonprofits are usually required to provide a report to the funding foundation that details how the funds were used. Endowments received from benefactors will also need to be properly managed.

What organizations use fund accounting?

Fund accounting is used in nonprofit organizations and government entities.There are currently 1.5 million nonprofit organizations operating in the U.S. today, ranging from early childhood education to hunger relief.

Amateur sports leagues are also nonprofits, as are animal welfare organizations. They’re all different, but the one thing they have in common is their funding streams. The majority of these organizations, and thousands of others like them, receive their funds through public support or through grants.

Unlike a for-profit business which reports to owners or stockholders, nonprofits and government entities report to the public, which is why they need an accounting tool that will help them properly account for the funds they receive.

Types of fund categories for nonprofit organizations

Nonprofits typically use three types of funds, with multiple revenue streams managed in each fund type. For instance, if your nonprofit has received three grants, each one of those grants will need to be recorded in the temporarily restricted fund account, since the grant has an expiration date (we’ll explain why later).

But you will also be tasked with creating a separate cost center for each grant in order to manage the funds properly. Each fund is handled like multiple companies would be handled in a for-profit business, with its own budget and financial statements.

Category 1: Unrestricted funds

Unrestricted funds can be used for any and all types of expenses that are incurred by a nonprofit, including overhead and administrative expenses such as salaries, rent, and utilities.

Because unrestricted funds are not earmarked for a particular program, they are highly sought after. Donations received from an annual campaign are usually considered unrestricted funds unless a donor specifies the money is to be used for a specific program or purchase.

If that’s the case, the funds should be moved to the temporarily restricted fund.

Category 2: Temporarily restricted

Temporarily restricted funds have been designated for a particular program or purpose. The difference between temporarily restricted and restricted funds is that a temporarily restricted fund has an expiration date, typically within a year.

For instance, a nonprofit organization may receive a donation in the amount of $5,000 that the donor states must be used to pay for a particular program before the end of the year. Grants are also considered temporarily restricted as they also have an expiration date.

Category 3: Permanently restricted

Permanently restricted funds are gifts, such as real estate, land, or mineral rights, that are held permanently, with the nonprofit able to use the income derived from the use of the asset.

Types of fund categories for governmental agencies

Like nonprofit organizations, government entities also use a type of fund accounting, usually referred to as encumbrance accounting, which budgets and reserves funds for specific expenditures. While government fund types are different, their purpose is similar.

Governmental fund accounting typically uses five fund types:

  1. General fund: The general fund tracks and records revenue and expenses that affect regular government operations. Revenue from gross receipts, sales tax, income tax, and interest generally go into the general fund.
  2. Permanent fund: A permanent fund works like an endowment, such as revenue earned from the sale or lease of natural resources like oil and gas, with any interest or dividends received from the lease used to pay for specific obligations.
  3. Special revenue fund: A special revenue fund is created to collect funds for a specific project. For instance, a $.02 tax on gas may be implemented in order to pay for road repairs. Several special revenues funds may need to be managed simultaneously.
  4. Capital projects fund: The capital projects fund tracks public resources used to fund a major capital project, such as a new power plant, pipeline, or building. Once the capital project is completed, the fund is closed.
  5. Debt service fund: Funds transferred into the debt service fund from tax revenue and other sources are used exclusively to pay principal and interest on any outstanding obligation bonds.

How does fund accounting work?

If you’re starting a nonprofit, you should consult an accountant or CPA who has experience in the fundamentals of accounting, particularly fund accounting basics.

A challenge for even experienced accountants, fund accounting can prove to be particularly challenging to those with little experience in the accounting field.

The most important step in fund accounting is creating a chart of accounts structure that will manage multiple funds properly. A standard chart of accounts would be structured as follows:

XXXX

For example, your general ledger account for supplies expense would be:

6100 - Supplies

To properly track multiple grants, programs, or campaigns, you would need to structure your chart of accounts into three segments:

XX-XX-XXXX

The first segment is the fund segment:

01 - Unrestricted

02 - Temporarily Restricted

03 - Permanently Restricted

The next segment is the cost center. If your nonprofit has three grants and two programs that need to be tracked separately, you could create your cost center segments like this:

10 - Foundation A Grant

20 - Foundation B Grant

30 - Foundation C Grant

40 - Hunger Relief Program

50 - Housing Assistance Program

Finally, your chart of accounts will use your standard account structure for recording revenue and expenses:

4110 - Unrestricted Revenue

4120 -Temporarily Restricted Revenue

4130 - Permanently Restricted Revenue

On May 10, you receive a grant in the amount of $25,000 from Foundation C. The grant would be recorded in your general ledger like this:

Date Account Debit Credit
5-10-2020 1000 - Cash $25,000
5-10-2020 02-30-4120 - Temporarily Restricted Revenue $25,000

On May 30, you purchase supplies in the amount of $230 while carrying out the programming stipulated in Foundation Grant C:

Date Account Debit Credit
5-30-2020 02-30-6100 Supplies $230
5-30-2020 Cash $230

Recording a donation is similar. For instance, you receive a donation on June 1 in the amount of $20,000 from one of your supporters. They stipulate that they want the donation to go towards the housing assistance program. Here is how you would record the donation:

Date Account Debit Credit
6-1-2020 1000 - Cash $20,000
6-1-2020 02-50-4120 Temporarily Restricted Revenue $20,000

Using segments enables you to easily track the expenses against any temporarily restricted donation, allowing donors and foundations the ability to see exactly how their funds were used.

It’s also important to note that nonprofit organizations use different financial statements:

  • Statement of Financial Position: The statement of financial position is similar to a balance sheet, displaying assets, liabilities, and net assets, including the restricted, temporarily restricted, and permanently restricted assets.
  • Statement of Activities: The statement of activities is similar to an income statement, but includes additional details such as current and prior-year totals as well as any budgeted totals and budget variances.
  • Statement of Functional Expenses: The statement of functional expenses is used to report on the activity of each program managed by the nonprofit.
  • Cash Flow Statement: The cash flow statement is the only report that is commonly used in both for-profit and nonprofit organizations, reporting on cash received from operating, investments, and financing activities.

Accountability is key in fund accounting

If you’re selling kites or providing consulting services, it’s likely that your customers care little about how you spend your money. Accounting for nonprofits is different. If you accept money from the general public or granting organizations, you need to provide details on how that money is used.

Using manual accounting methods and spreadsheets can be challenging for any business, and even the use of T-accounts will do little to stem the resulting confusion if you’re trying to track multiple funds manually.

If you’re ready to make the switch to an automated system be sure to check out The Blueprint’s accounting software reviews and make your life much easier.

LOTS TO CONSIDER, LET US HELP

Get The Blueprint’s latest recommendations by signing up to our free newsletter.

The Motley Fool has a Disclosure Policy. The Author and/or The Motley Fool may have an interest in companies mentioned.